Driving Profitability Despite Rate Cuts
Portfolio Managers Dave Ellison and Ryan Kelley discuss how interest rate cuts have affected banks, the health of the banking industry, currently low valuations, and opportunities in non-bank financials.
David EllisonPortfolio Manager
Ryan C. Kelley, CFAChief Investment Officer and Portfolio Manager
How do interest rate cuts affect banks’ profitability?
In general, banks’ net interest margins (the difference between income generated from loans and the cost of funds) narrow when the Federal Reserve cuts rates and longer-term yields stay flat or decrease. A narrower margin impacts the profitability of smaller banks more than larger banks because a larger percentage of small banks’ revenue comes from net interest income. Smaller banks usually generate little fee income from other business lines.
For example, approximately half of large-cap of J.P.Morgan’s revenues are fee-related and from sources other than the net interest margin. BB&T Corporation, a large regional bank, has about a 60%/40% split between net interest income and fee income. Conversely, Hingham Institution for Savings, a longterm holding in the Hennessy Small Cap Financial Fund, derives approximately 98% of revenues from net interest income. While a higher net interest margin is desired, banks have managed their balance sheets well since the Financial Crisis. Earnings have generally grown as banks have reduced their exposure to bad loans and implemented operating efficiencies to reduce expenses.
Please provide an update on the health of the banking industry.
Overall, the banking industry is very healthy and operating metrics remain strong relative to history. For example, large-cap banks enjoy the following operating ratios:
- Return on assets are at 1.4%, the highest since 2003.
- “T1” capital ratios, which measure financial strength, are about 13% at the largest U.S. banks, a decades-long high-water mark for the industry.
- Asset quality is impressive with a low number of non-performing loans. In 2009 non-performing assets as a percentage of total assets was close to 3%, approximately 4-5x the current level.
- Net loan charge-offs at commercial banks over the past six years have averaged below 0.5% of total loans compared to their worst period in 2009 at about 2.7%.
- The number of bank failures has declined significantly over the past decade, dropping from a peak of 157 in 2010 to just four in the past two years.
In addition, mergers and acquisitions remain steady. In 2019, M&A activity has included some bigger companies transacting larger deals. Year-to date through mid-October 2019, there were over 200 private and public bank transactions, with an aggregate deal value of $48 billion, the highest in the past decade.
How do current bank valuations compare to historical averages?
We believe many banks with strong fundamentals are trading at attractive valuations below longterm averages. Over the past nine years, large-cap banks’ average price to earnings has been around 13x. Currently they are trading at about 11x next year’s earnings. Banks are also at a significant discount to the S&P 500® Index, which is trading at approximately 17x next year’s earnings.
For the Large Cap Financial Fund, what opportunities are there in non-bank companies?
The Financials sector has become more diverse and now includes many fast-growing non-bank companies. We believe the strength of our actively managed portfolio is our ability to focus on companies we believe offer significant value and catalysts for positive change. Currently, the Hennessy Large Cap Financial Fund is comprised of approximately 20-25% regional and diversified banks, with 75-80% of the Fund’s assets invested in non-bank businesses, such as credit and payment services, insurance, brokers, and financial exchanges.
Many of these firms have less exposure to credit, the shape of the yield curve, and bank regulations as pure banks. In addition, some non-bank companies could offer compelling growth opportunities relative to the S&P 500® Index. These non-banks also benefit from a backdrop of a solid economy, a low unemployment rate, and a strong consumer.
Two of the largest holdings in the Hennessy Large Cap Financial Fund are Visa and Mastercard. Data processing is more prevalent and becoming more inexpensive, and these companies benefit as they process a higher number of transactions at a reduced cost.
What are the potential drivers for small-cap banks?
We continue to see several drivers for small-cap banks. Smaller banks have been experiencing modest loan growth, in part because the lending environment remains conservative and generally risk adverse. As a result, smaller banks have high-quality
loans on their books.
Bank management is also focused on increasing efficiencies to lower costs and drive earnings growth. Finally, small banks may benefit from continued M&A activity and consolidation in the banking industry.
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